I figured I’d let 2009 go out with a bang and post another of my contrarian views: 2010 will be rough for Goldman Sachs. Why? Well, to know the answer to that, you should head on over to the Huffington Post where the full piece is online.
Happy New Year!
Well, Citi reported earnings this past week. And, as many of you know, there are a few reasons you’ve heard to be skeptical that this was any sort of good news. However, there are a few reasons you probably haven’t heard… (oh, and my past issues on poor disclosure are just as annoying here)
On Revenue Generation: First, here are some numbers from Citi’s earnings report and presentation, Goldman’s earnings report, and JP Morgan’s earnings report:
These numbers should bother Citi shareholders. Ignoring the 1Q08 numbers, Citi–whose global business is much larger and much more diverse than it’s rivals–generates no more, if not slightly less, revenue than the domestically focused JP Morgan and much, much less than Goldman. But it gets worse. Goldman’s balance sheet was $925 billion vs. Citi’s $1.06 trillion in assets within it’s investment banking businesses, roughly 10% larger. I’d compare JP Morgan, but they provide a shamefully small amount of information. As an entire franchise, however, Citi was able to generate their headline number: $24.8 billion in revenue, on assets of $1.822 trillion. JP Morgan, as a whole, was able to generate $26.9 billion, on assets of $2.079 trillion. JP Morgan, then is 14% larger, by assets, and generstes 8% higher revenue.
These numbers should be disconcerting to Citi, it’s no better at revenue generation than it’s rivals, despite having a larger business in higher growth, higher margin markets. Further, in an environment rife with opportunity (Goldman’s results support this view, and anecdotal support is strong), Citi was totally unable to leverage any aspect of it’s business to get standout results… and we’re only talking about revenue! Forget it’s cost issues, impairments and other charges as it disposes assets, etc.
On The Magical Disappearing Writedowns: Even more amazing is the lack of writedowns. However, this isn’t because there aren’t any. JP Morgan had writedowns of, approximately, $900 million (hard to tell, because they disclose little in the way of details). Goldman had approximately $2 billion in writedowns (half from mortgages). Citi topped these with $3.5 billion in writedowns on sub-prime alone (although they claim only $2.2 billion in writedowns, which seems inconsistent). But, that isn’t close to the whole story. Last quarter, in what I could find almost no commentary on during the last conference call and almost nothing written about in filings or press releases, Citi moved $64 billion in assets from the “Available-for-sale and non-marketable equity securities” line item to the “Held-to-maturity” line item. In fact, $10.6 billion of the $12.5 billion in Alt-A mortgage exposure is in these, non–mark-to-market accounts. There was only $500 million in writedowns on this entire portfolio, surprise! Oh, and the non–mark-to-market accounts carry prices that are 11 points higher (58% of face versus 47% of face). What other crap is hiding from the light? $16.1 billion out of $16.2 billion total in S.I.V. exposure, $5.6 billion out of $8.5 billion total in Auction Rate Securities exposure, $8.4 billion out of $9.5 billion total in “Highly Leveraged Finance Commitments,” and, seemingly, $25.8 billion out of $36.1 billion in commercial real estate (hard to tell because their numbers aren’t clear), are all sitting in accounts that are no longer subject to writedowns based on fluctuations in market value, unlike their competitors. These are mostly assets managed off the trading desk, but marked according to different rules than traded assets. If one doesn’t have to mark their assets, then having no writedowns makes sense.
On The Not-so-friendly Trend: This is a situation where, I believe, the graphs speak for themselves.
Do any of these graphs look like things have turned the corner? Honestly, these numbers don’t even look like they are decelerating! Compare this with the (relatively few) graphs provided by JP Morgan.
These aren’t directly comparable, as the categories don’t correspond to one another, and JP Morgan uses the more conservative 30-day delinquent instead of Citi’s 90+-day delinquent numbers. However, JP Morgan’s portfolio’s performance seems to be leveling out and even improving (with the possible exception of “Prime Mortgages”). Clearly, the pictures being painted of the future are very different for these institutions.
On the Stuff You Know About: I’ll be honest, this business about Citi benefiting from it’s own credit deterioration was confusing. Specifically, there is more going on when Citi refers to “credit value adjustments” than just profiting from it’s own Cittieness. However, Heidi Moore, of Deal Journal fame helped set me straight on this–the other things going on are dwarfed by the benefit I just mentioned. Here’s the relevant graphic from the earnings presentation:
And, via Seeking Alpha’s Transcript, the comments from Ned Kelly that accompanied this slide:
Slide five is a chart similar to one that we showed last quarter which shows the movement in corporate credit spreads since the end of 2007. During the quarter our bond spreads widened and we recorded $180 million net gain on the value of our own debt for which we’ve elected the fair value option. On our non-monoline derivative positions counterparty CDS spreads actually narrowed slightly which created a small gain on a derivative asset positions.
Our own CDS spreads widened significantly which created substantial gain on our derivative liability positions. This resulted in a $2.7 billion net mark to market gain. We’ve shown on the slide the five-year bond spreads for illustrative purposes. CVA on our own fair value debt is calculated by weighting the spread movements of the various bond tenors corresponding to the average tenors of debt maturities in our debt portfolio. The debt portfolio for which we’ve elected the fair value options is more heavily weighted towards shorter tenures.
Notice that Citi’s debt showed a small gain, but it’s derivatives saw a large gain (the additional $166 million in gains related to derivatives was due to the credit of it’s counterparties improving). Why is this? Well, notice the huge jump in Citi’s CDS spread over this time period versus cash bonds, which were relatively unchanged. Now, from Citi’s 2008 10-K:
CVA Methodology
SFAS 157 requires that Citi’s own credit risk be considered in determining the market value of any Citi liability carried at fair value. These liabilities include derivative instruments as well as debt and other liabilities for which the fair-value option was elected. The credit valuation adjustment (CVA) is recognized on the balance sheet as a reduction in the associated liability to arrive at the fair value (carrying value) of the liability.
Citi has historically used its credit spreads observed in the credit default swap (CDS) market to estimate the market value of these liabilities. Beginning in September 2008, Citi’s CDS spread and credit spreads observed in the bond market (cash spreads) diverged from each other and from their historical relationship. For example, the three-year CDS spread narrowed from 315 basis points (bps) on September 30, 2008, to 202 bps on December 31, 2008, while the three-year cash spread widened from 430 bps to 490 bps over the same time period. Due to the persistence and significance of this divergence during the fourth quarter, management determined that such a pattern may not be temporary and that using cash spreads would be more relevant to the valuation of debt instruments (whether issued as liabilities or purchased as assets). Therefore, Citi changed its method of estimating the market value of liabilities for which the fair-value option was elected to incorporate Citi’s cash spreads. (CDS spreads continue to be used to calculate the CVA for derivative positions, as described on page 92.) This change in estimation methodology resulted in a $2.5 billion pretax gain recognized in earnings in the fourth quarter of 2008.
The CVA recognized on fair-value option debt instruments was $5,446 million and $888 million as of December 31, 2008 and 2007, respectively. The pretax gain recognized due to changes in the CVA balance was $4,558 million and $888 million for 2008 and 2007, respectively.
The table below summarizes the CVA for fair-value option debt instruments, determined under each methodology as of December 31, 2008 and 2007, and the pretax gain that would have been recognized in the year then ended had each methodology been used consistently during 2008 and 2007 (in millions of dollars).
Got all that? So, Citi, in it’s infinite wisdom, decided to change methodologies and monetize, immediately, an additional 290 bps in widening on it’s own debt. This change saw an increase in earnings of $2.5 billion prior to this quarter. In fact, Citi saw a total of $4.5 billion in earnings from this trick in 2008. However, this widening in debt spreads was a calendar year 2008 phenomenon, and CDS lagged, hence the out-sized gain this quarter in derivatives due to FAS 157 versus debt. Amazing.
And, while we’re here, I want to dispel a myth. This accounting trick has nothing to do with reality. The claim has always been that a firm could purchase it’s debt securities at a discount and profit from that under the accounting rules, so this was a form of mark-to-market. Well, unfortunately, rating agencies view that as a technical default–S&P even has a credit rating (“SD” for selective default) for this situation. This raises your cost of borrowing (what’s to say I’ll get paid in full on future debt?) and has large credit implications. I’m very, very sure that lots of legal documents refer to collateral posting, and other negative effects if Citi is deemed in “default” by a rating agency, and this would be a form of default. This is a trick, plain and simple–in reality, distressed tender offers would cost a firm money.
The Bottom Line: Citi isn’t out of the woods. In this recent earnings report I see a lot of reasons to both worry and remain pessimistic about Citi in the near- and medium-term. If you disagree, drop me a line… I’m curious to hear from Citi defenders.
There is a lot of chatter about different plans, market anticipations, and pitfalls when it comes to “fixing” the economy and, specifically, nationalization. Despite the fact that I don’t have the same reach as several uneducated members of the media, I figured I’d share what I think the way forward is, regardless.
Step 1: Nationalize Citi and Bank of America. Let’s be honest, with recent talks of expanded stakes, ringfenced assets, and no end of the losses in sight, it’s probably time the U.S. Government came to grips with the fact that they already own the losses and the positive impact of letting shareholders keep the upside is nonsensical. Further, these institutions will need more money for a long time to come. And, if you’re paying attention, you know that the markets seem to twist and turn with the news coming out of financial institutions. Nationalization rumors depress the markets, talks of further government action scare away new capital, and the fundamental health of these firms makes current investors run.
Step 2: Begin lending. With so much chatter and anger about institutions not lending, it almost makes me wonder why there is such a deep lack of understanding. These sick institutions are trying to shrink their balance sheets and have a ton of souring assets on them. They have to raise capital to support their current asset base, so why do we really expect these banks and other firms to lend? Some would claim that lending for the sake of lending got us into this mess, but they are either telling only part of the story or don’t get it–excessive leverage and poor risk management got us to this point. In fact, I suspect that defaults on even the riskiest loans would be much lower if bank capital was free enough to continue making mortgage loans based on normal requirements for returns and risk/reward.
So, how do we begin lending? Simple, start a government bank. Well, not exactly, but the government now owns Fannie, Freddie, AIG, Citi, and BofA (see step 1). Clearly the government now (by step 2) has the infrastructure and technical know-how to manage the logisitical issues of setting up and running a lending platform. Now the government can lend directly and not wait for sick banks to do it. Further, they can underwrite to fairly normal lending standards and get a premium return on their capital. Also, rather than poaching the nationalized entitites’ “talent,” the government cam employ many out of work finance workers throughout the country (after all, lending in Missouri should probably be done by people in Missouri).
Step 3: Begin replenishing bank assets with new, cleaner assets. With all of these souring assets on the books of banks, their capital base being eroded, and leverage decreasing, TARP capital is probably being deployed very inefficiently and, obviously, conservatively. Well, since step 2 involves lending and creating assets, the government should then implement an auction process–all assets the government creates would then be auctioned off, much like treasury bonds are, to banks. Since the government would be lending based on normal underwriting standards (as compared to the previous paradigm of loan underwriting), these assets would have a strong credit profile and will likely perform much better than legacy assets. JP Morgan, for example, should jump at the chance to generate higher levels of retained earnings by buying assets when the rates it needs to pay are at historically low levels, once its capital frees up. This solves the chicken-and-egg problem of curing sick banks, hurting from consumer defaults and depressed economic activity, to free up the credit markets and getting economic activity to increase despite a lack of credit.
One could easily permute this plan in many ways. One possible way is to offer to swap new assets for legacy assets at current market levels to facilitate a much more immediate strengthening of the banks’ balance sheets. Another variation could include some partial government guarentee on assets it originates. I’m sure there are thousands more ways one could add bells and whistles.
Step 4: Broaden the Fannie and Freddie loan modifications and housing stabilization plan to the government’s new properties. I suppose this should be some sort of addendum to step 1, but it’s important enough to require some emphasis on it’s own. With Citi and Bank of America being so large, I’m sure the housing stabilization plan will have a much broader reach once those are wards of the state. We’ve all heard the arguments for stopping foreclosures and refinancing borrowers… When the house next door is foreclosed upon, your house loses tens of thousands of dollar in value, increases housing supply, etc.
Step 5: Break up the institutions that are owned by the government. Markets have been clamoring for Citi to be broken up for years. Bank of America shareholders probably want Merrill to be broken off A.S.A.P. (ditto for Countrywide). Chew up these mammoth institutions and spit out pieces that, in the future, could fail because they aren’t too big. This should be done to AIG, Citi, Bank of America, and both Fannie and Freddie.
Step 6: Immediately implement a new regulatory regime. This is pretty much a “common sense measure.” President Obama has begun to call for this, and it’s pretty clear that with no more major investment banks around, the S.E.C.’s role needs to be re-defined. I’ve already laid out my thoughts on what this new structure should look like.
Between all of these steps, we should have the tainted institutions out of the system, credit will start to free up, banks asset base will become more reliable, and systemic risks will go down as we significantly decrease the number of firms that are “too big to fail.” Seems logical to me…
Okay, on the Bailout, I’ve been silent for a while. Mainly because it’s not the same from day to day and my thoughts change a lot… Also, John McCain decided he should get in the mix, although Americans seem to have disagreed, and confused the whole thing… But today I heard some things that prove the Republican party, specifically the House of Representatives’ Republicans, are complete and utter idiots.
From Politico:
House Republicans say the potential losses for the taxpayer are excessive. Rather than purchase bad assets, one alternative would be to extend government-backed insurance for the securities with industry paying a fee for the added coverage that could improve their value.
(Emphasis mine.)
Okay, geniuses, what are you going to charge for this magical insurance? I don’t have to remind readers that there is no way to determine this… If one could know what “insurance” like this would cost then they would know what the underlying securities were worth. Oh, and let’s not forget that the same person who would have to use this authority, Hank Paulson, thinks it’s useless..
“Frankly, he said, ‘If that was added as an option, it wouldn’t hurt, but I couldn’t use it,’” the chairman said of his discussion with Paulson. As for Frank himself? “I wouldn’t mind, but it doesn’t do anything. It’s useless but not harmful,” Frank said. “The problem was in displacing the other stuff.”
(Emphasis mine.)
Oh, and these same stupid partisan arch-conservatives cited Fannie and Freddie as proof that mortgages can be insured… Need an educated person, with even a minimal knowledge of finance and current events, say anything more?
My favorite, though, is how the House Republicans, just like the Underpants Gnomes, want to suspend the capital gains tax so that the economy can recover (“Step 1: Remove Capital Gains Tax, Step 3: Economy Fine”)! What do they say?
“By encouraging corporations to sell unwanted assets, this provision would unleash funds and materials with which to create jobs and grow the economy,” an outline of the proposal said. “After the two-year suspension, capital gains rates would return to present levels but assets would be indexed permanently for any inflationary gains.”
(Emphasis mine.)
Someone needs to tell these free market champions the definition of the word “gains” …
To be sure this is a complicated problem. However, having idiots running around pandering to their base with senseless proposals that are counter-productive complicates things further.
As for the other provisions? Well, I think one needs to step away from their “Wall St.” hat here and look at what’s best for everyone… For many reading this blog I anticipate that’s a hard thing to do. In general, oversight is something I support. I also think that companies that want to avail themselves of public money should give the taxpayers some upside and assurance that they won’t be rewarding people who were responsible for this problem in the first place. How does one implement those things? Seems like the consensus bill being reported gets closer than the other proposals… We’ll have to see what emerges.
What a weekend. I’m sure Wall St. feels a bit brutalized by the events. Now, here are my questions…
1. Doesn’t Lehman have to be involved in moving trades that are facing them? I simply do not understand what the “Lehman Risk Reduction Trading Session” is all about. Indeed, if one looks at the I.S.D.A. Novation Protocol Guide, it’s the case that the “Transferor” (the “Stepping out party”) needs to agree on certain terms. For example:
Negotiating a proposed Novation Transaction:
The Transferor will contact the Transferee to agree a price [sic] for the Novation Transaction.
Seems like “negotiating” and “to agree” seem to indicate the transferor has some decisions and veto power. Also, let’s be honest, all the banks sitting at the table for this situation showed that they aren’t willing to lend a helping hand to their competitors and are acting in self-interest while potentially risking the entire system’s stability (more on this in a bit). How do we know they will be candid with each other and the world regarding their exposures? If I were a bank, I would seek to novate all the in-the-money trades with Lehman and not the ones that are out-of-the-money, right?
And, now that Lehman is winding down, the trades that will be novated away could be hedges. So you have Lehman, sitting with assets it now needs to sell, as their hedges are being novated away and without the ability to put new hedges on. What does this mean? Lehman, in trying to recover maximum value for creditors, will now have to sell quicker or will be holding assets that are unhedged and much more exposed to further market deterioration. Something just doesn’t make sense with this whole thing…
To further complicate things, since the holding company is filing for chapter 11, not chapter 7 does that trigger this special session? Does it matter which entity it is? I suppose we’ll see. Oh, and then there’s this that seems to indicate there’s really no reduction of risk occurring at all, from the W.S.J.:
Some traders said it was difficult to find new counterparties for many of their outstanding trades with Lehman. The snags included different terms and maturity dates on derivatives contracts, and market prices changed rapidly Sunday afternoon. “People were screaming at each other over the phone, asking: How can this work?” one trader said.
William Gross, chief investment officer at bond-fund giant Pacific Investment Management Co., said very few Lehman trades were offset. “There’s an immediate risk related to the unwind of these positions,” he said.
(Emphasis mine.)
2. How is a solvent company with a recovery plan, on Wednesday, now insolvent? If you say it’s similiar to Bear or you mutter the words “run on the bank” then you’re either making something up or you have insider information that has been reported nowehere in the media. Proof? From the W.S.J.’s Marketbeat Blog:
“Ongoing pressure and anxiety in the markets resulted in significant cash outflows toward the week’s end, leaving Bear with a significantly deteriorated liquidity position at end of business on Thursday,” the agency wrote.
Lehman’s prime-brokerage business is smaller than Bear’s relative to its more diverse portfolio, Mr. Sprinzen noted. And Lehman doesn’t depend on hedge-fund clients’ free credit balances to the same extent. In Bear’s case, the “run on the bank” by prime-brokerage clients was a major contributor to its fall.
(Emphasis theirs! [Again, wow!])
Lehman’s prime brokerage certainly isn’t anywhere near large enough to bring down the firm, as was Lehman’s. So, did the Fed and Treasury cause this? By trying to set up a suitor did they make other firms unwilling to fund them and thus cause their death?
Remember that there was consensus before that Lehman could survive.
3. The Treausury and the Fed have a lot of decisions to make. What will they do? Why did they choose this path?
First, it was earlier reported that the Merrill-Bank of America tie-up would be unde-rcapitalized and need regulatory approval. That reference, from the New York Times article has since been removed.
Second, A.I.G. is now hunting for government loans to survive. How can they provide those when they refused Lehman? How can they refuse those when they provided them for Bear? A.I.G. is hardly at the center of the financial system. And, by the way, they went from selling units to not selling units and needing loans in a matter of hours!
Also, what of stability? First, Lehman is just as at the center of credit derivative markets as Bear Stearns was, in corporate credit default swaps and interest rate derivatives probably more-so. And what’s to stop people asking questions and begin to pummel Morgan Stanley or Goldman Sachs?
As Barry cites, perhaps the Fed has caused it’s own problems here:
To be eligible for a bailout, firms must also demonstrate a particular genius for screwing up. Before it went bust, Bear Stearns had a monstrous $33 of debt for every dollar of capital, and hedge funds it owned destroyed hundreds of millions of dollars of clients’ cash. It got a bailout. Lehman Brothers, which has taken painful measures to reduce its risk, is perversely less likely to get direct government help. “The worst Lehman can do is destroy the firm,” said Barry Ritholtz, CEO of Wall Street research firm FusionIQ and author of the forthcoming Bailout Nation. “Bear Stearns, on the other hand, set up the firm so that if they screwed up, they could threaten the entire financial system.” That may explain why Treasury Secretary Paulson has thus far resisted providing federal succor to Lehman.
(Italics theirs.)
4. As for Lehman’s assets, who gets them and what are the terms? I would claim that there should be an auction run. And, perhaps, when that auction is run there would be enough capital to save Lehman? Well, Lehman owns those assets at a different leverage ratio so how would that play? Depends on the price. We have to see if investment banks, like Goldman, did the math and withheld capital from a rescue assuming they could buy the assets on the cheap later.
Okay…. more to come, but that’s what is initially sitting uneasily with me.
Well, there was an announcement from Merrill about some things:
Now, while all these are important, #2 is better covered elsewhere as I think reliance on insurers was stupid to begin with and #3 is what it is… best left for analyst reports for nuance, but very generally obvious. Let’s go to the release…
Merrill Lynch agreed to sell $30.6 billion gross notional amount of U.S. super senior ABS CDOs to an affiliate of Lone Star Funds for a purchase price of $6.7 billion. At the end of the second quarter of 2008, these CDOs were carried at $11.1 billion, and in connection with this sale Merrill Lynch will record a write-down of $4.4 billion pre-tax in the third quarter of 2008.
… [The] sale will reduce Merrill Lynch’s aggregate U.S. super senior ABS CDO long exposures from $19.9 billion at June 27, 2008, to $8.8 billion, the majority of which comprises older vintage collateral – 2005 and earlier. The pro forma $8.8 billion super senior long exposure is hedged with an aggregate of $7.2 billion of short exposure…
Merrill Lynch will provide financing to the purchaser for approximately 75% of the purchase price. The recourse on this loan will be limited to the assets of the purchaser. The purchaser will not own any assets other than those sold pursuant to this transaction. The transaction is expected to close within 60 days.
(emphasis mine).
Now, this is (via the WSJ via naked capitalism) 22 cents on the dollar. Wow! But, to be honest, this is sticker shock that comes from the massive liquidity being used here. The bid someone shows you on $30 billion versus $30 million is a very different proposition. This sounds like advice I gave before (see item #1 on that post). Now, what questions should the analysts be asking? Note the bold, italicized, underlined parts above. Seems as if the purchaser will be an entity, most likely formed for this transaction, that will only need 25% of the $6.7 billion, or $1.675 billion. Now, since the other 75% is financed, what happens if losses start flowing to these CDOs? The amount of equity decreases. From the Journal …
Many CDOs held by Merrill were viewed as highly likely to default and lose some or most of their principal value. Of around 30 CDOs totaling $32 billion that Merrill underwrote in 2007, 27 have seen their top triple-A ratings downgraded to “junk,” according to data compiled by Janet Tavakoli, a structured-finance consultant in Chicago. Their performance has been “dreadful,” she says.
(emphasis mine).
So now Merrill is in a race. Up to 78% of notional value can be written down, now, with no one taking a loss. Then the next $1.675 billion falls to Lone Star’s equity, and then the rest come out of capital Merrill has put up for the benefit of Lone Star. With the above downgrade statistics such losses aren’t completely out of the question. With this in mind, I would want to know the financing terms. The devil is in the details. Such financings could require only some margin up front in addition to the 25% equity, or none at all. The financing terms could limit Merrill’s ability to claw back more capital as the assets see further writedowns. In general, these terms could mean the risk is only cushioned, not removed. I’m sure these questions will be asked, and that Merrill anticipated such questions. This makes me think that these issues lead to the depressed price–price was the one protection potentially preventing Lone Star from having to have to cough up more money (you can’t owe money if the assets are performing better than their price implies). However, if these terms aren’t very favorable (Merrill was trying to get rid of these assets, after all) one might not ever see the financing terms. It’s also possible that Merrill retains some equity upside in these assets. I guess we’ll wait and see…
Well, it looks like the dust has settled on the situation. My predictions have actually fared quite well–lawsuits, retention bonuses, brokers jumping ship, and some interesting rumblings about management seeking out new bidders.
Bloomberg even highlighted Jamie Dimon’s greenmail:
Dimon made the proposal to several hundred Bear Stearns senior managing directors at a meeting yesterday evening in the securities firm’s Manhattan headquarters, according to two people who attended. He said members of the group who are asked to stay after the acquisition is complete will get additional JPMorgan shares, according to the attendees, who asked not to be identified because the meeting was private.
Bear Stearns employees own about a third of its stock, with a large concentration in the hands of senior managing directors. Their support may help JPMorgan counter opposition from billionaire Joseph Lewis, who owns 8.4 percent of Bear Stearns and said yesterday he may seek an alternative to the bank’s proposed purchase.
“He’s basically bribing them for their votes,” said Richard Bove, an analyst at Punk Ziegel & Co., referring to Dimon’s presentation. “In this environment, there are no jobs on Wall Street, so he can bribe them by letting them keep their jobs and they’ll vote for him.”
Lots of people have opined on the merger terms and the possibilities for other bidders, and even some odd provisions that suggest no one knows the entire story yet. Everyone who reads my blog knows what I think on the obvious points. Here’s an interesting fact, too, that I haven’t seen elsewhere. From the Times Online:
A counter-offer for Bear Stearns would face a series of hurdles. Part of the JPMorgan Chase offer, which values Bear at $2 a share, includes the financial support of the Federal Reserve Bank of New York, which has underwritten $30 billion of the most toxic of Bear Stearns’s investments. The New York Fed also extended special financing to JPMorgan to cover the cost of Bear Stearns redundancies and impending litigation. Any new bidder would have to convince the central bank that it should transfer its underwriting to support a new offer.
(emphasis mine).
Wow. Talk about a sweet deal! I’m not sure what that sentence means, but I know I haven’t seen that anywhere else, so I remain skeptical, but it wouldn’t surprise me. So, with this heavy handed approach, here’s a question: Why does the Fed care so much about ensuring the specific deal they got JPM to ink goes through? In the above Deal Journal post, it’s made clear that the Fed wants this deal to go through. So, if there is another bidder out there, at a higher price, then why does it matter who gets Bear? Certainly the crisis they were talking about ha been avoided, no? Let’s examine the facts (from a myriad of sources):
These actions seem inconsistent. Why would you force a securities firm to be bought, but then allow other to borrow at the discount window? Why would you make a 28 day loan, and then, with not much else changing, force another alternative? Why would you try to get JPM to accurately asses the value of Bear, and then, when they are unable to do so, both guarantee the most troublesome assets and allow JPM to lock in a very low bid price?
Now, I hate to be trite, but the taxpayers now own $30 billion dollars of stuff that is nearly impossible to value and, simultaneously, not going up in value (leaving only flat or down). JPM shareholders are getting roughly $1 billion in incremental earnings (I, obviously, would claim that when all is said and done that number will be lower, but that’s their number and we have no reason to believe that they don’t believe it to be accurate) for a fraction of the outlay in cash (and potentially not even the legal expenses, if indeed the above statement from The Times Online is true). And all the while, the Fed is standing guard over the gasping, bleeding body of Bear Stearns warding off further bidders? This isn’t the kind of intervention that I can honestly say sounds “above board.” To me, one either let’s Bear file for bankruptcy protection or they are bailed out–forcing a suitor onto them seems a bit weird.
Now begins the next chapter in this saga, exploring who profited from the demise of Bear and the source of the rumors that caused this whole mess.
Wow. What a difference a day makes. Bear Stearns is now, apparently, being fire-sold for $2 a share to avoid being fire-sold for the values of it’s assets minus it’s liabilities.
I was reading the WSJ piece on the topic, and it seems like there was a lot of pressure applied by the Fed to ensure Bear got sold, with no regard for shareholders (the article states this, in essence). So counterparty risk is now secure. Great! But wouldn’t it have been better to run a real process and determine the value of the company? Wouldn’t it have been more valuable to not send the message that the “health of the financial markets” is more important than a firm’s sale occurring at their true equity value? (And aren’t both of those, taken together, a contradiction? Mis-valued assets was how this mess got started.) So, let’s make some bold predictions! I don’t think they will all be right, but they are obviously all reasonable to me. I’ll show my hand and give the probability I ascribe to the prediction coming true, as well.
Prediction: Lots of shareholder lawsuits. K.K.R. was looking a bidding, so was J.C. Flowers, and the Fed says the deal needs to be done today, so they get crammed out. Who do you sue? Everybody of course! Hence JPM estimates $6b in costs for this transaction, first item listed–litigation. Probability: 100% (Bonus prediction: Someone notable from Bear joins in a lawsuit or files one themself! Probability: 50%)
Prediction: The price gets raised. A process wasn’t run, shareholders will demand more, and the Fed is taking $30 billion in risk. For $1 billion in accretion to earnings, and not even being in the first loss position on the toxic assets Bear is holding, why pay such a low price? This will become a problem for JPM. Keep in mind, this can be raised (the pruchase price) by having to pay out certain shareholders more than the bid price. For example, employees they wish to retain might have shares made whole at a higher level than the sale (you have 40k shares of BSC, you get $40 in JPM stock for each share if you stay, for example). Probability: 70%
Prediction: JPM will never see some of those assets add to their franchise. If the prime brokerage business really saw the kinds of outflows reported by the media (from Bear, that is) JPM could already be finding itself over-paying for that asset. And the mortgage and securitization business at Bear? Management for that business are at the top of that market in terms of knowledge and relationships–watch that business experience brain drain quickly. Probability: 70%
Prediction: Integration will be a nightmare. Culture clash will occur at many points in the process and within many businesses. JPM and Bear’s cultures aren’t compatible. Bear is a very raw environment and is very cut-throat. You’ll see this get ugly, fast. Big names on both sides will leave and power struggles will be common. Perhaps this is normal merger behavior, but it will be worse because the Bear employee have already been financially destroyed. You’ll see resentment for JPM from ex-Bear employees and silos form within the firm. It will be difficult to interact with certain parts of the firm depending on where you worked when JPM bought Bear. Ouch. Probability: 60%
Well, that’s it for now. I’m sure much more information will leak out as this deal develops. If this drags on or lots of game-changing information comes to light, I might revisit these later.
Citi is in a troubled spot. There is clearly bad news that is anticipated to come out as securitized products do worse, but there are many criticisms being leveled at Citi and it’s senior managers for not doing enough to fix the situation. Here are a few suggestions (in case Vikram is reading):
1. Respect the conservation of risk. If you move assets into a special group you still own the assets! Now, it’s clear what the thought was–one could over hedge this book, work out of the positions, and make money doing it. Want to guess what happened? It didn’t work (isn’t working). The items that one can mark-to-model, and that seem to have solid credit characteristics, keep. As for the other assets, figure out fair value, contact fifteen smart firms with deep pockets, sell them these assets at a discount, finance the sale, and take a ten percent residual equity stake in any upside. Firms are doing this left and right. No more writedowns coming on toxic crap.
2. Cut the dividend. Actually, instead of cutting it, set a very specific plan (a formula, for example) for how much the dividend will be. In quarters where there is no revenue, or negative revenue, there is no dividend. Now your capital conservation is linked to your capital needs.
3. Senior management should align themselves with the shareholders. It’s somewhat a public relations move, but if they start taking all their compensation in options, announce a very public set of criteria for linking their pay to the performance of the firm, and even have some senior managers forgo compensation (they can afford it) then the amount of “skin in the game” will be elevated and it will be a big vote of confidence in the company. Maybe senior members whose purchases are tracked publicly should buy some shares.
4. Communicate. The market is left to rampant speculation if it hears nothing. Further, since not saying anything usually means there is nothing good to say, the worst is assumed. If there will be layoffs, announce that. If Citi will need to raise capital, announce that. The C.E.O. has said nothing of how he intends to remedy the situation (an oft-repeated criticism). And, though this relates to #6 (below), when you do “waves” of layoffs, the rumor-mongering and having CNBC report things that may or may not be true for all your employees to see, you risk a major exodus of anyone who is mobile (read: talented). This leads me to…
5. Focus on the problem. I have never understood how it becomes the formula for getting out of a big problem to cut jobs. It makes no sense. There is a top line (revenue) and a bottom line (profit), and costs (due to compensation, for example) are an important item in between, but there is a maximum impact managing that item can have. First of all, people that are paid on Wall St. are very efficient to carry–their bonus can be zeroed. If they leave, well, you would have cut their job anyway; if they stay, you have a free option on a known quantity if conditions improve. In any event, if revenues are negative, then you don’t look good by any measure, so spend time working on getting revenues up! I see the numbers, and the amount firms save from not having to pay for people per year, even if you assume they all make $2 million dollars, is a small, small fraction of what’s being lost due to writedowns. Going around the globe and have presentations made to you about Citi’s business in that country is a poor use of a C.E.O.’s time when there is still a set of assets on the balance sheet that have the potential for tens of billions of more dollars in writedowns.
6. End the war on morale. Really. Do I really have to point to examples? Naming old co-workers to key roles? Acquiring hedge funds that haven’t even raised money (well, $150MM)? Buying an odd-fitting shop comprised of former colleagues and giving them the same seat at the table as a large, much more established, group already operating within the firm? Siding with your old shop in a dispute, and agreeing to a worse deal (paying the other shop’s expenses!) than if the original trade has just been pushed through (and destroying value for third parties whose money you are supposed to be managing)? Seriously?
7. Consider breaking up the company. If you can find a buyer for the parts of the company with the toxic crap, then sell it and go from there. The theory is sound, but the execution has failed. There is not one culture, there many warring sub-cultures. Citibank versus Salomon Brothers versus Smith Barney … it sounds like a brawl, and quite often that’s what it is. When one calls over to Citi, no one there even answers the phone the same way (“Citi” “Salomon” “Citigroup”). Also, I would imagine that while the fixed income division at Citi had been producing great returns (from being in businesses that have produced billions in writedowns) it was getting more resources, resources (such as balance sheet) that could have been invested in areas that are now more stable and didn’t create a debacle. (An argument for companies to specialize? Perhaps.)
What do the above steps accomplish? Well, Citi’s balance sheet is freed of toxic crap. The people who work in this behemoth are given some clarity as to their future, they don’t feel like senior management is giving shareholder money to their friends at a breakneck pace, and they all have a set of goals to work towards (once the course is laid out). Oh, and hopefully their employer can remain financially solvent!
Dear John Thain 